Is the Fed creating an asset bubble? And other views from around the horn.

Michael Aloi |

On Wednesday, the Federal Reserve voted 8-2 to lower interest rates from 2.25% to 2%. This is the first interest rate reduction since 2008. Fed Chairman Jerome Powell said this was a "mid-cycle adjustment" and signaled caution on expecting future rate cuts. However, he did leave the door open to reduce rates further saying the bank will "continue to monitor the implications" and act appropriately. What could this rate cut mean for investors? Is this rate cut a good thing or what problems could it cause? Let's take a look: 

The Good

The Wall Street Journal summed it up best when it said the Fed's rate cut is akin to "purchasing insurance." Powell's justification for the rate cut included protection from "downside risks" notably trade disputes which could cause manufacturing to weaken further, slower global growth expectations, and persistently low inflation. The stock market finished down Wednesday, possibly driven by investors who expected a deeper rate cut. However, Lord Abbett portfolio manager Kewjin Yuoh thinks the 2% rate is favorable for investors and "should be supportive of a continued low-volatility environment." Moreover, Yuoh thinks risk assets should recover on the stronger fundamentals. That's good news in the near term for stock investors. 

The Bad

I was on a conference call yesterday hosted by JP Morgan Asset Management and the lead speaker thought the Federal Reserve's cut was to paraphrase him, dipping one's hand in the cookie jar. What he meant by this is once the Fed, the market, the economy, and the American public get a taste of rate cuts, or a cookie, it's going to be hard to have just one. If that's the case, it may be difficult to wean the market off expectations of further rate cuts. This is especially a problem if the Fed needs to raise rates to counter inflation. There's a reason there were 2 dissenting votes yesterday. 

Federal Debt and the Federal Funds Rate. Source: St. Louis Fed

The Ugly

The recent rate cut doesn't help fixed income investors or those trying to live off the interest in their portfolio. Just when savers were getting accustomed to higher CD rates and money market rates the rug is pulled out from under them so to speak. Lower rates may cause these investors to reach for yield elsewhere and dip into riskier/higher yielding asset classes. These assets are already inflated due to higher market valuations. Investors need to be careful about this. 

Lower rates also cause 'looser monetary policy' which can mean corporations will borrow more, consumers will borrow more, and sovereign nations will borrow more. Ray Dalio, CEO of hedge fund Bridgewater Associates, has been warning about the implications of a debt crisis for years -- now might be a good time to start reading his latest book, you can download the free e-book, here: Principles for Navigating Big Debt Crises. Mr. Dalio is not alone. UBS CEO Sergio Ermotti and Guggenheim Partners Scott Minerd both are sounding the alarm, you can read more in the National Real Estate Investor's "The Dark Side to Rate Cuts". As Warren Buffett has often said, we only learn who is swimming naked when the tide goes out. 

What do you think? I'd like to hear your thoughts. Please feel free to email me.